Response to James Kroeger

January 20, 2011 § Leave a comment

The Set up:

In October of 2010, James Kroeger wrote a long piece for Daily Kos that was a response to an ‘affluent conservative’ regarding conservative ideas about the effects of taxation on investment, employment, and the overall economic health of the nation.  Mr. Kroeger presented his response as a definitive attack on the basic assumptions of conservative economic thought (okay, Kroeger says that other people told him they could use it as a definitive attack on the basic assumptions of conservative economic thought…but he’s just being modest, he believes its awesome!).

What I found most interesting about formulating a response to Mr. Kroeger is how obvious it was that he had never tried using these arguments against a conservative who knew anything, at all, about how the economy, business, or the monetary system works.  Mr. Kroeger has a Master’s in Economics, yet he makes sweeping generalizations about how the economy works that no economist I’ve studied under would have dared undertake.  Two things are important to note about Kroeger and his economic theories:  Economists aren’t financiers, so beware when they start talking about how finance works.  And, any time an economist sounds too sure about anything, they’re probably faking it.

The Response:

As a conservative, an MBA, and an armchair economist, I appreciate the lengths to which James Kroeger has gone in this response to conservative economic dogma.  Under scrutiny, however, Mr. Kroeger’s arguments fall short of laying to rest the debate over whether or not taxes have a dampening effect on our economy.

James says that when conservatives talk about taxation sucking money out of the private sector that we assume that “all of the money that the government will be collecting…is money that would otherwise have been put to productive use.” That’s not exactly true. It’s not a matter of saying that every dollar taxed is a dollar that would have been invested; but it is absolutely fair to say that a dollar taxed is a dollar that will not be invested.  That lost option for private investment is the opportunity cost of taxation.

In a similar oversimplification to the above, James tries to draw a stark contrast between economic and financial investments, initially ignoring that economic investment and financial investment can have overlapping effects. For instance, one company’s expense (i.e., not a cost of goods sold), such as advertising, is another firm’s revenue. A paper mill’s revenue is based on the advertising agency’s expense (non cost of goods sold). So, to say that money spent on advertising (for instance) isn’t growing the size of the economic pie is myopic, and ignores it that our economy is increasingly reliant on services and not manufacturing.

James backs off of the myopic view two paragraphs later, but manages to acknowledge the overlapping nature of economic and financial investments while misrepresenting the nature of the overlap. For instance, on the topic of a land purchase (which Mr. Kroeger claims is non-economically stimulating): That represents a financial investment to the buyer of the land, and an infusion of cash to the seller. The seller of the land now has cash to engage in what James would consider financial investing (economically stimulating).

Similarly, Kroeger claims that stock investments are not economically stimulating; He says that once the stock is sold as an IPO, any subsequent gain or loss is felt in the secondary market, not to the company that issued the stock.  However, while the increasing value of existing stock may not create immediate cash flow for the underlying business, the business is still acutely concerned with it’s stock performance. Why? Well, for one, key employees are often compensated in part by stock, so the performance of the stock encourages them to take economic risks in order to grow the business. This risk takes the form of economic investing activity (investment in production, human resources…etc). In addition to personal economic motivation, managers of public firms are concerned with the stock price because they want to be able to go back to the market for new rounds of public financing. Again, companies that show a history of growing revenues and profits have superior stock performance, and that makes it easier for them to raise money with new stock offerings. Jame’s inference that the only time companies go to the market is an IPO is blatantly wrong. Companies issue new stock all the time, it is part of the normal means of financing operations.

Jame’s misunderstanding of how financing works, and how the underlying business is driven by it’s stock performance, tinge the next few paragraphs, because from his misunderstanding of those issues, he goes on to make incorrect assumptions about the impact of the capital gains tax on economic investing. Again, the financial investment that is represented by stocks absolutely does effect the economic output of the traded company. But, we also must remember that most companies are not publicly held, but are private enterprises, and the owners of those corporations are also taxed on the capital gains of that business when they take dividends. If investments in private business are not as attractive as less economically productive investments because of the change in the risk profile that the higher capital gains rate represents, then the capital gains tax does have a negative impact on investment activity that would create jobs.  Without a bit of evidence being presented, I will concede that there isn’t a 1:1 correlation between a an increase in the capital gains tax and a decrease in investment activity (both economic and financial), but I think only a fool would say that there isn’t some correlation between the two.

James next creates a straw man by setting up an opposing argument that nobody on the right seems to be making: That a reduction in capital gains tax represents a special incentive to invest in capital goods. On the contrary: an increase in the capital gains tax is a special disincentive to investment. By any other logic, any tax rate under 100% would have to be considered a ‘special incentive’ to motivate some activity. And that is exactly the logic James applies when he says that “additional” government provided financial incentives are a waste of tax dollars; put another way, James is saying that any amount of private money that isn’t collected by the government is a loss of revenue to the government. What a terrifying concept. Conservatives take the view that, with very few exceptions, additional market-provided financial incentives to the government (taxes) are nothing more than a unnecessary waste of private dollars.

James then acknowledges the risk calculation that all investors (which entrepreneurs are) must undertake when deciding whether or not to invest their time, effort, money, and identity in some endeavor. What he ignores is how the tax environment plays into that calculation. Taxation represents an additional barrier to profitability to the entrepreneur, and nothing more.

The next couple of paragraphs outline a theme of confusion that runs throughout Jame’s diary. If lower tax rates do nothing but encourage what James would call non-economic investing like savings, then that glut of savings will eventually drive interest rates down. The lower interest rates will force investors to take more risk, and some of that increased appetite for risk will benefit entrepreneurs who James claims has nobody to turn to but the government for financing. In a high tax environment, the incentive of investors is to seek relatively safe, long-term, established investments regardless of the lower potential returns. Consider two environments, one in which the capital gains rate is 30%, and another in which the capital gains rate is 15%. Now, consider two investments of different risk profiles, one in which you calculate an 80% probability of a 10% return, and another in which you calculate a 40% probability of a 20% return. the tax rate has become a major factor in my risk assessment of these two potential investments (if the capital gains rate was zero, then I’d be far more likely to take the greater risk for the potential of greater return, since the lack of capital gains tax has increased my take if I win).

My favorite failure of James assessment is the assertion that 85% of the money corporations spent on investments came from internally-generated funds, and that is completely separated from the savings rate. Here’s why: even after James acknowledges that 20-30% of borrowing is done by consumers, he doesn’t draw the connection that is obvious: the cash flow that companies use to invest (those internally generated funds) still comes from savings that is being lent out to consumers.

He tries to close of debate on this subject by going into how the Fed creates money. What he ignores is the effect of the creation of funds on the market. Yes, the Fed ‘creates money’, and it does that a lot (the money supply has grown 300% since 1973), but when the Fed creates the money to be lent out, it creates inflation. Inflation is just a tax by another name. There is no free lunch – the Fed cannot replace savers as the source of lend-able funds without a cost to the market. The cost is that, while companies still get credit, their inventories become more risky to carry (you can’t have your inventory setting around for long if you’re losing money in real terms constantly), and so they produce less.  Consumers have even less incentive to save when the Fed creates inflation, which requires the Fed to create more money for lending, which makes investments more risky, and further discourages production and savings.

James goes on to make another logical mistake by assuming that we can tie excess employment capacity (unemployment) to some concept of excess savings (savings, as opposed to investing — if people are saving money that isn’t leading, directly, to economic growth, James believes that the government should take that money and use it to invest in new business ventures). Unemployment has many causes aside from a lack of invest-able funds. For instance, perhaps the welfare system provides a sufficient standard of living for some portion of the available workforce as to create a disincentive to work. Perhaps constant increases in efficiency means that consumers simply can’t consume enough (regardless of disposable income) to eat up all the capacity for production. Perhaps the means of production have been sent to other countries, so that no amount of consumption could create jobs in the consuming country.

What Mr. Kroeger really seems to be arguing for is limitless risk.  People should be allowed to invest their own money as long as they aren’t investing it in ways that doesn’t lead to immediate job growth (i.e., they can buy land and build a strip mall, but they can’t buy land and let it sit — after all, we have the government for setting up parks).  We can buy IPOs, but not blue chip stocks.  If people don’t invest in enough risky ventures, then the Fed should just print money and do it for them.  If the debt gets too large to support all that cash creation, then the Fed can just buy up land and buildings and infuse the system with cash that way.  But, under no circumstances should a dollar rest, it should be moving at all times, under all circumstances.  If you fail to spend every bit of your check on IPOs and consumer goods, then the government should get everything you’re not using to invest in some new business that the market has rejected.  Kroeger may have passed his economics courses, but I wouldn’t have him managing my investment portfolio.



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